The expectations going into the June 28-29 EU summit were extremely low. There was a sense up until late in the evening on the 28th that the entire summit could collapse in acrimony. Up until the evening of the 28th the Italian and Spanish heads of state were essentially playing a game of blackmail, threatening to scuttle the entire summit unless short-term measures were enacted to lower their nations' borrowing costs through collectively financed purchases of their nations' sovereign bonds.
Thus, in this context, the fact that EU leaders agreed on anything is being experienced as a major relief by global financial markets participants.
However, when one examines the details of the agreement - and especially the lack of details thereof - there is little to get excited about. First, there was absolutely nothing new in this agreement that should have surprised anybody given that everything agreed to had already been publicly pre-approved by Germany. Second, the steps approved at the EU summit had been universally perceived as insufficient by market participants prior to the meeting.
Far from serving as a source of optimism, everything about this agreement merely serves to highlight the fact that a major economic crisis in Europe is virtually inevitable.
The Futility Of The EU Agreement
The full text of the EU summit agreement can be read here: It must clearly rank as one of the most non-committal "agreements" in the history of international summitry. Let's review the key points:
1. The most important aspect of the agreement was opening the "possibility" of the ESM (European Stability Mechanism) providing bailout funds directly to banks rather than through loans to sovereigns (which would then recapitalize the banks). The advantage of this is that the resulting debt will not appear directly on the balance sheet of the home countries of the banks being bailed out. However:
A) Direct ESM financing of the banks is a mere "possibility" that is being conditioned on a whole slew of prerequisites. The first condition is the creation of a centralized bank supervisory apparatus in which sovereign nations will give up much or all of their real power to regulate banks. Second, it has been agreed that the bailouts should also be subjected to "appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalized in a Memorandum of Understanding." Finally, the text of the agreement makes it clear that ESM funding will only be possible after the centralized regulatory mechanism is established and that the matter should be "considered" by the EU Council before the end of 2012. Thus, the prospect of direct ESM bailouts for European banks is neither immediate nor even certain.
B) The ESM has an upward limit of $500B of funds that it could eventually deploy. These funds are purely theoretical at this point because they have not even been raised yet. For the sake of argument, let us suppose that the funds are raised successfully by the ESM. Let us also assume that the currently projected $100B is used for Spain's bank bail-out. Ireland, Greece, Portugal and banks from other European countries will also want bailout funds for their own banks. (Ireland's Prime Minister has been loudly saying that they want in and the text of the agreement suggests that this request will be granted). Thus, realistically AT LEAST $200B of the $500B will be devoted to bank recapitalization. That leaves a theoretical $300B to purchase sovereign debt. That is peanuts; it does not constitute a credible vehicle to control the sovereign debt crisis. Most analysts agree that a minimum of 2 trillion euros would be needed to constitute a credible sovereign bond backstop.
2. The other main aspect of the EU agreement is that the ESM will be allowed to "backstop" sovereign debt via purchases in the primary and/or secondary markets. That is not news. This possibility has always been recognized, even by the Germans. However, as pointed out above, this looks like a paper tiger.
A) The potential $500B (which is really $300B after subtracting bank recap funds) has not even been raised by the ESM -- and it may be very difficult to raise it. After all, who wants to lend to an entity that is "backed" largely by Italy, Spain, Greece and Portugal? Within the ESM framework, the combined "guarantees" provided by the PIIGS to ESM creditors are in fact proportionately more important than the guarantee provided by Germany. If the experience of the EFSF is any guide, the ESM may have great difficulty in raising $500 billion euros for this and other reasons. In fact, the difficulty may be even greater since ESM creditors will not be granted "preferred creditor" status, as EFSF creditors were.
B) As pointed out above, even if the $500B can be successfully raised, it will not be nearly enough to capitalize European banks and serve as a credible bond-buying mechanism.
C) The possibility of the ESM getting levered financing from the ECB - the only way that the ESM could become credible in terms of size -- was conspicuously excluded as a possibility. The idea has been flatly rejected by various nations and the ECB time and time again.
D) The ability of the ESM to buy sovereign debt is limited by all sorts of conditions. For example, purchases would be conditioned on the beneficiary countries complying with stringent fiscal agreements and austerity programs. The problem is that there is no way that Spain can comply with their fiscal agreements and conditions. So as of now, the entire sovereign bailout possibility is mute.
E) ESM funding to purchase sovereign debt will require memorandums of understanding that may require unanimous approval from member states. This can hardly be taken as a given. Finland, for example, has suggested that it will not support such ESM funding unless the borrower countries provide real collateral such as gold reserves.
In sum, the summit produced an "agreement," and an agreement is better than a collapsed summit. But there are no real solutions here.
The most important thing to keep in mind is that the Spanish and Italian economies are in the midst of a serious collapse in investment and consumption and this collapse will not be halted by this agreement. The consequence of the economic collapse is that neither Italy nor Spain will be able to meet any of the conditions that are required to receive funding. This brings us back to square one. Unless something is done to halt the collapse of the Spanish and Italian economies these agreements are utterly futile.
Thus, within a matter of days or weeks, global financial markets should resume their downward descent. I reaffirm my target of 950-1,020 for the S&P 500. While I do not recommend shorting for average investors, aggressive investors can consider shorts (or long puts) on (SPY), (DIA), (XLB), (XLY) or long (VIX) or (VXX).
Additional disclosure: I am long VXX calls and long SDS